Pentagon official sees defense M&A slowed by budget impasse

WASHINGTON (Reuters) - The Pentagon's top manufacturing official expects a spate of merger and acquisition activity - and a doubling of efforts by foreign companies to take over U.S. arms makers - once the uncertain U.S. budget outlook becomes clearer.

Deputy Assistant Secretary of Defense for Manufacturing and Industrial Policy Brett Lambert told Reuters in an interview that prolonged uncertainty about U.S. military spending was stalling M&A; deals, dampening investment and hiring by big defense companies. It takes an even heavier toll on their small-to-medium-sized suppliers.

Lambert, who will retire on August 31 after four years on the job, said one of his biggest concerns was that banks were increasingly unwilling to lend to smaller defense firms because of fears that their contracts with bigger companies would materialize as quickly and fully as expected.

Gridlock in Congress on deficit-reduction measures - and the prospect of $500 billion in additional cuts in military spending, on top of $487 billion in cuts already planned - have slowed a long-expected consolidation in the defense sector.

Lambert said the uncertainty had undercut banks' confidence in the U.S. government's ability to follow through on weapons contracts, and smaller companies in particular were paying the price.

"At the second and third-tier level, what you're finding is that people are just running out of cash, and nobody will extend them credit because nobody has full faith and credit in the U.S. government anymore," he said in his nearly empty Pentagon office.

Lambert cited a recent call from the president of an upstate New York bank who told him his loss of faith in the government limited his ability to lend to smaller companies.

Lambert, who co-founded and later sold DFI International, a national security consulting firm, said his company had routinely sought and received 90 percent, 120-day loans secured by contracts with bigger defense players. Such loans helped the company invest and hire more people to work on those contracts.

The amount of the loans dropped to around 60 percent during the 2007-2008 global financial crisis, but uncertainty about the impact of the additional budget cuts required under the "sequestration" process had squeezed that percentage even lower, he said.

"Nobody believes that the government is actually going to pay these contracts off because they keep getting cut back and pushed to the right," Lambert said.

Industry experts have expected an uptick in mergers and acquisitions in the defense sector for years, given the prospect of big cuts in military spending after over a decade of sharp growth. But the flood of expected deals has remained a sporadic trickle, given prolonged uncertainty about future budget levels.

Lambert said the situation could turn on a dime if and when investors felt sure about the U.S. budget outlook.

"When it happens, it'll happen fast," he said. "As soon as they have some clarity, you'll see a lot of action: second-tier, third-tier consolidation, more foreign interest."

The U.S. defense market, home to Lockheed Martin Corp. , General Dynamics Corp. , Raytheon Co. , Boeing Co. and others, remains the largest in the world. "As bad as sequestration is, we're still the largest game in town," Lambert said. "We spend over a billion dollars a day."

He also cited growing foreign interest in the U.S. defense industry, noting that the interagency Committee on Foreign Investment in the United States examined over 100 proposed foreign acquisitions last year.

"I think you'll see that double in the next few years," Lambert said. "It's a sign that the U.S. economy is one of the strongest in the world and everyone wants to invest here."

But in the meantime, he said weapons makers, investors and U.S. military officials are waiting for the government to take decisive action on U.S. budget deficits, instead of the paralysis now gripping Congress.

"Everyone is waiting for them to do something. We just need stability. We don't care if it's up or down," he said. "Industry knows how to manage down. They just need to know what down is."